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Old 06-21-2011, 04:41 PM   #1

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Relative Strength - Internal

Hi,

Relative Strength (RS) is one of the most basic concepts in Technical Analysis, like trend analysis or mean reversion. However, it is seldom talked about in discussion boards and often ignored by beginners.

Some people might be acquainted about RS in reference to CANSLIM and similar investment screening (Intermarket approach). However, RS is a generic concept which can be used for trading in all time frames and implemented with almost any technical strategy.

I’ll discuss it with basic examples here, looking forward for comments from fellow traders.


DD
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Old 06-21-2011, 05:06 PM   #2

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Re: Relative Strength

Relative Strength (Internal)

Consider Two Stocks:
1. A stock which is trading ‘relatively stronger’ than its movement last week
2. A stock which is trading at same levels as last week (range bound)

The first one is obviously a better buy candidate than the second. I will talk about measuring RS using few indicators and PA practitioners may wonder whats the point behind maths for such simple things. Well, this thread is just about concepts and for those using (or looking to use) indicators will find this useful.

To measure this RS we can simply start with the crux behind RSI. Wilder, the founder of RSI based it upon RS of a stock which can be defined as:
RS = Average of Up days price movement / Average of Down days price movement

The raw RS moves too fast so we can smooth it using SMA(20). The Amibroker formula for RS is:
Code:
// Code for plotting Wilder’s Relative Strength
function RS_Raw( period )
{
P = N = 0;

result = Null;

for( i = 1; i < BarCount; i++ )
{
diff = C[ i ] - C[ i - 1 ];
W = S = 0;
if( diff > 0 ) W = diff;
if( diff < 0 ) S = -diff;

P = ( ( period -1 ) * P + W ) / period;
N = ( ( period -1 ) * N + S ) / period;

if( i >= period )
result[i] = P/N;
}
return result;
} 

Plot( MA(RS_Raw( 14 ), 20), "20 Day Smoothed RS", colorBlue );
You may like to plot RS and RSI in same window and notice similar charecterstics:
  1. In uptrending market, both RSI and RS move in upper half of their range. Similarly, for downtrending market they move in lower half of range.
  2. Divergences and Reversals
  3. Sharp movements indicate that market is overbought or oversold

Infact, many indicators measure the same under different names. The ADX suggests buying when +DI crosses over –DI. The Plus Directional Movement (+DI) equals the current high minus the prior high, provided it is positive. Similarly, Minus Directional Movement (-DI) equals the prior low minus the current low, provided it is positive. Conceptually this means that the stock is changing from downtrend to uptrend; OR, it trading ‘relatively stronger’ to past week/month. The ADX itself is used to measure the strength or weakness of a trend, not the actual direction.

I will stop writing now and wait for comments to explore other ways to measure internal RS.


DD
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Old 06-22-2011, 05:28 PM   #3

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Re: Relative Strength

Relative Strength (Internal) Continued...

RS internal can be measured as
1. Size of Upward movements vs Downward movements
2. Momentum of Upward movements vs Downward movements

It will be worthy here to look at Aroon indicator. The Aroon indicator is unique because it focuses on time relative to price, while typical momentum oscillators focus on price relative to time. It measures how much time passed between the highest (up) or lowest (down) since the beginning of a period (in percents). A 14-day Aroon-Up measures the number of days since a 14-day high. A 14-day Aroon-Down measures the number of days since a 14-day low.

The value of Aroon declines as the elapsed time between a new high (low) increases. The difference of Up & Down Aroon lines is called the Aroon Oscillator. It's positive value indicates an upward trend (or coming trend), and the negative value indicates a downward trend.

There are three stages to an emerging trend signal. First, the Aroon lines will cross. Second, the Aroon lines will cross above/below 50. Third, one of the Aroon lines will reach 100.


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Old 06-29-2011, 12:55 PM   #4

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Re: Relative Strength - Internal

Thank you Do Or Die for these awesome explanations. I just recently learned about RSI and haven't completely learned how to use it. On my broker's website, they only have the RSI and lets you adjust the periods. It's set to 14, but I'm not really sure what would be the best way to set it. Also, how do you measure it compared to the industry? I also don't have access to the Aroon indicators. Do you know of any websites that have these indicators?

So if the RSI is in the upper half range, it is in and uptrend. Does this also work for the short term? How exactly do I use it? I know this isn't the only indicator but in terms of the RSI, when would be the best time to buy? When it's up? When it's down but heading up like some other momentum indicators?

Again thank you so much. I appreciate it when people take the time to explain things to the beginners like myself. (I wasn't sure whether I should post this in this thread or the new one so I'm sorry if you prefer it in the other one).
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Old 06-29-2011, 02:58 PM   #5

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Re: Relative Strength - Internal

I'll elaborate on RSI today evening or tomorrow with examples.

Two good free sites are:
FreeStockCharts.com - Web's Best Streaming Realtime Stock Charts - Free
Free Stock Charting Software | Technical Analysis

As per your overall approach; I'll say pick up one thing, and do not move to another unless you are acquainted with it. Going through several indicators/techniques can be confusing. Try gather as much concepts as you can, before jumping to conclusions (I will follow same approach in my threads).

For generic questions, I will be happy if you can post here: http://www.traderslaboratory.com/for...ed-stocks.html

DD
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Old 06-29-2011, 03:04 PM   #6

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Re: Relative Strength - Internal

Thank you so much! I will be looking forward to hearing from you again. And yes I will post generic questions in that thread from now on.
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Old 06-29-2011, 03:15 PM   #7

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Re: Relative Strength - Internal

Wow I just used the first free chart website you mentioned and it is really great. It is way better than the one my broker has. I didn't realize how much I was missing. Thanks! I'll try the second one soon too.
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Old 06-30-2011, 08:54 AM   #8

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Re: Relative Strength - Internal

Hi Umfan92,

I'm using your stock S for examples- will look forward to more examples from your side in this thread
-----------------------------------------------------------
Case Study- The RSI Indicator

The RSI has been one of the most popular indicators over a decade. A lot of chartists have talked about its peculiar ability to turn up and down in patterns which can mirror precisely the price behavior. However, like most other oscillators in its category, people start to doubt it for the trouble it gave in trending markets- going up the limits of its excursion and bouncing around there for weeks or months until the trend finally reversed. The common adage is- use oscillators for sideways markets and other indicators for trending market.

But the problem is- the market does not make announcements about its price behavior. “Hey DD, I will start trending from next week, so please find other set of indics.” And the adage turns to theoretical BS. We will take a fresh look at what RSI captures from the background of above posts on RS.

Calculation:

RSI is calculated as 100 – 100/(1+RS). This is a smart formula which takes care of:
  1. Too frequent whipsaws and erratic movements are eliminated. The RSI remains remains amply responsive to price movement because an increase of the average close up is automatically coordinated with a decrease in the average close down and vice versa.
  2. The question of how high is high and how low is low is answered because the RSI value must always fall between 0 and 100. This allows measuring the momentum of any number of instruments on the same scale for comparison to each other and to previous highs and lows within the same instruments. The most active instruments can be filtered by the criteria that RSI is showing the greatest vertical movement— either up or down. (RSI > 75 or RSI<25)
  3. The formula is quite simple unlike Commodity Channel Index. This helps in relating easily to the basic concept of relative strength in prices.



You can relate the above diagram to charts of any liquid trading instrument.

The RS illustrates changes in momentum (note that the slope in RS curve can be much sharper than price change). The terms ‘RS Internal’ and ‘momentum’ can almost always be used interchangeably. I’m sticking to using RS Internal to relate it to the broader picture of market analysis which I will gradually share.

The direction of RS (price acceleration) can be increasing or decreasing. Decreasing RS in a downtrend may be sustainable. But in a sideways trend it will indicate exhaustion of current price move; in an uptrend, decreasing momentum will signal the trend reversal with a good probability. From this observation we can conclude the following:
  1. In a healthy uptrend, the RS will not reach the lower parts of its range. RSI typically moves in the range >40 in an uptrend while touching >70 area often. In a downtrend it will remain below 60 and move toward <30 area often. If it’s moving up and down frequently to 35/65 levels, perhaps the market is not trending at all. (attached img1 & img2)
  2. In an uptrend if the RSI sharply decreased to below 30, it will indicate a reversal. Similarly for a downtrend, if it suddenly rises above 70, it will indicate a reversal. These conditions are called ‘Mega Overbought’ and ‘Mega Oversold’ respectively.
  3. In an uptrend if momentum decreases gradually but significantly over time, it indicates a reversal. This condition is called Divergence. After a uptrend in prices make a double top or triple top, it shows up in RSI as Failure Swing.
  4. For trading in a congestion area or slow trend, RSI peaks and troughs can be used for buying/selling.
  5. Since RSI directly mirrors turns in prices, we can use it for marking trendlines similarly as in prices. Pennants and Flags are important patterns, and if you can find them distinctly (occur rarely) on RSI, most likely the stock will start a fresh move in the direction of RSI breakout.

In the examples note that in img1 everything looks perfect for a trend reversal; but actually if you check the following price action the stock gets stuck in a range before resuming downtrend. This will happen all the time; no indication can assure certainty, you cannot give a prophecy about future prices. Yet you can see the RSI indicated very strongly to close any long positions before prices resumed downtrend (img3). The analysis turned out perfectly for the reversal in uptrend (img4)

Implementing the Theory:


Suppose you are trading in a sideways/congested market. If the RSI rises into the 65 area you may liquidate 50% of your position. If the RSI rises into the 75 area, you can liquidate remaining position. These RSI levels have a history of indicating exhaustion of the buying for the price run.

Your stop-loss orders can also be tightened in a similar fashion; at the RSI 65 level, they can be moved just over the 5-day moving average; at the RSI 75 level, they will be just at the lowest price of previous day.

Similarly for trending markets, you can use divergence to liquidate half of your position and tighten your stops for remaining of position. A mega overbought condition can be used to reverse your position. For tightening the stops, you can use a shorter term time frame such as 120-minutes with a moving average of higher period. (In general, trend following trades are of a longer duration than mean reversion trades).

I have used RSI with 15 periods because it falls in the most commonly used parameters. I will use the most common parameters in other examples too. You will need proper experience and/or backtesting to arrive at a system.

The parameters will also depend upon the time frame used. Short-term investors (holding periods 2-18 months) may like to note that the area for very tight stops in a bear market will not be at same ratio as in a bull market. The reason is bears march at more than thrice the speed of bulls (markets falls at >3x speed than it rises). The markets have a tendency to be more protracted while bottoming out. Knowing this allows you to tighten your stop-loss orders or to liquidate your positions at levels that are not as steep in bear markets as in bull markets. Over the years, this method will ensure that profits can be taken when the market has had an extended run or a very steep price increase.

It will be good to take up some examples from other instruments and other time frames. There is some more stuff on divergences which I will elaborate soon.


DD
Attached Thumbnails
Relative Strength - Internal-img1.png   Relative Strength - Internal-img2.png   Relative Strength - Internal-img3.png   Relative Strength - Internal-img4.png  
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